By David Sterman
As Standard & Poor's gears up to prep the next group of companies to join the S&P 500, investors are trying to game the system by buying stocks that have a strong chance of graduating into this famous index. In an earlier article, I looked at a group of companies that were solid candidates, according to Credit Suisse, and also provided a look at the most impressive companies in the S&P 400 mid-cap index. The top firms in that index often matriculate to the S&P 500 when they reach maturity.
I took a close look at all of the companies that appeared in the first part of this series, and there were some great companies in the mix. If price were no object, I'd be a huge fan of:
- Oceaneering (NYSE:OII): This name is prospering form the ongoing trends toward undersea naval warfare and undersea oil drilling. Oceaneering is poised to grow at a sustained double-digit pace, which is something few other defense contractors can say.
- Cree (NASDAQ:CREE): LED lighting is a revolutionary game-changer, and Cree's heavy emphasis on R&D is leading the charge toward ever-lower prices for these low-energy light sources that also have remarkable longevity compared to regular bulbs. Still, profit margin gains may be tough in a very competitive environment.
- Polaris Industries (NYSE:PII): If Winnebago's (NYSE:WGO) recreational vehicles are suitable for retirees, Polaris has become the go-to name for activity-oriented vehicles. Notably, it has a revenue base that is four times larger than Winnebago as well. If S&P wants to position for future demographic trends, then Polaris is a great choice.
I love these companies, but I don't love their stock prices, and I'd prefer to wait for some sort of pullback before singing their praises. That said, there are two investment ideas that hold great appeal on their own. If they get added to the S&P 500, then they are also set up for a timely trade.
1. HollyFrontier (NYSE:HFC): When oil refiners Holly Corp. and Frontier Oil decided to merge in 2011, it was a match made in heaven. Both companies had worked separately to greatly enhance their abilities to process heavy crude oil, and the combined entity is now the nation's leading refiner of this difficult-to-process crude. Heavy crude always sells at a discount to light sweet crude, as most refiners would rather work with the easier-to-refine crude. Yet HollyFrontier's management has cracked the code, and the company's state-of-the-art refineries take advantage of the cheaper, heavier crude -- but they can turn it into gasoline, diesel and other distillates at same price that other firms require to process light sweet crude.
You can see the payoff from heavy spending on refinery upgrades by looking at HFC's gross margins. They rose from 10% in 2008 to 11.5% in 2010 to more than 20% last year. Margins will likely fall a bit this year as crude oil prices rise faster than distillate prices, but HFC's margins should still be in the 15% to 20% range. And that margin compression has caused this stock to fall more than 20% since the end of winter.
But the sell-off has been a bit myopic. After all, the U.S. is in the midst of an energy boom, and our domestic crude oil, and the refined products that will ensue, are expected to replace imported refined products. The key takeaway: HFC and other refiners should see rising volumes in coming years due to import displacement. Meanwhile, shares are attractively priced at less than 10 times projected 2014 profits. And though the company's stated formal dividend equates to 30 cents a share per quarter, the company keeps delivering special one-time dividends as well, and if you tally them up, the trailing 12-month yield for this stock is 6%.
2. Reinsurance Group of America (NYSE:RGA): I've been singing the praises of insurance stocks throughout 2013, and though they have started to make solid upward moves, they are still quite undervalued. As long as their balance sheets are worth more than the public market value of their stocks, then you should pounce.
This reinsurer (which insures the insurance companies against catastrophic payouts) is a perfect example. At the end of the second quarter, tangible book value stood at $82.97 a share. That's roughly 24% above the current stock price. And RGA is doing what any "below book" stock should do: buying back shares. The current buyback will be fueled by a $400 investment that should shrink shares outstanding by more than 5%.
Another plus: RGA has hiked its dividend by at least 25% in 2010, 2011, and again in 2012. And in early August, the payout got another 25% boost. As I've noted before, buybacks should take precedence over dividend hikes as long as shares trade below book value, but attention to both flanks never hurts.
Risks to Consider
Possible inclusion in the S&P 500 should not be seen as the sole basis for an investment in these firms, especially considering that an invite may not come for another year or two.
Look for a quick 2% to 3% pop when any of these companies get the invite to join the S&P 500. Both HollyFrontier and Reinsurance Group of America hold great intrinsic appeal, even if Standard & Poor's never comes knocking.